A wave of distressed debt and special situations funds has hit the market in recent weeks in response to the Covid-19 pandemic downturn, jumpstarting a segment that had dwindled to almost an afterthought of private credit investing. Nearly a dozen new or expanded funds are seeking about $30 billion in capital, led by Oaktree Capital Management’s $15 billion effort that alone would bring in nearly as much as the entire distressed debt segment
raised all of last year.

Other big names jumping in the market or adding capacity to existing fundraising efforts include PIMCO, Fortress Investment Group, Highbridge Capital Management, Cerberus Capital Management, and Atlantic Park, a joint venture between General Atlantic and Iron Park Capital Partners that is raising $5 billion.

That’s a big change from a relatively sleepy 2019, which featured 19 funds closing with about $19.1 billion in aggregate capital, down from the recent high of 29 funds closed in 2017, according to data from Preqin. Distressed strategies were a small slice of the 151 private credit funds that closed last year with $104 billion in aggregate capital, most of that in direct lending vehicles, according to Preqin.

But the rush of new distressed strategies responding to the coronavirus economy may not be done yet, says Alan Pardee, a managing partner at Mercury Capital Advisors, a placement agent firm.
“Any fund platform that is credit-oriented is currently in the market or devising how to be in the market soon with a distressed debt version of themselves,” he says. “We’ve seen people who are still taking those steps, and would not be surprised to see other funds joining the present group.”

Limited partners and consultants are not surprised by the rapid shift, with many closely studying the new landscape for investing, says Andrew Angelico, v.p. at Wilshire Associates in its manager research group.

“It has been interesting to see how quickly the opportunity set has opened up or transitioned,” he says. “It was a less interesting area to be in for a couple of years, but with Covid-19 and the energy and oil disruptions, we’re seeing opportunity sets open up. We’re actively sharpening our pencils… as the dislocation, economic impact, and price realization rolls through the capital markets.”

Oaktree’s effort, the latest version of its distressed debt flagship fund, would be the largest ever raised in the category. The strategy aims to buy debt from struggling companies or launch takeovers through corporate restructuring efforts.

General Atlantic and Iron Park Capital – led by former GSO Capital founder Tripp Smith – are teaming up for their $5 billion effort, aiming to provide financing to companies facing distress during the downturn, according to the Wall Street Journal. Fortress is raising a new $3 billion pool aimed at downturn-created opportunities that will complement the $5 billion credit opportunities fund it closed last November, says a source familiar with the matter. Meanwhile, PIMCO is launching a new $3 billion distressed

vehicle, Highbridge is seeking $2.5 billion across two funds, and Cerberus is planning on raising $750 million, a target upped after the crisis began, as reported.

Some firms have already finished their efforts, including Kayne Anderson Capital Advisors, which quickly raised and closed a $1.3 billion real estate opportunistic debt fund in recent weeks, building on its existing real estate debt strategy with a vehicle focused on distressed lending and buying opportunities, says a source familiar with the effort.

Others have just begun, with Angelo Gordon pivoting off of the $1.8 billion credit solutions fund it closed in February to now raise an “annex” to that strategy focusing on downturn-related investments, which has brought in about $650 million, along with two other new $750 million funds focused on real estate debt and structured credit, according to Bloomberg News. The San Mateo County Employees’ Retirement Association already committed $25 million to the annex fund earlier this month, according to MandateWire. And KKR has used the shell of its third special situations fund, which it began raising last year with a $1.5 billion target but later suspended, to launch a new dislocation opportunities fund that is aiming to invest in several areas, starting out with about $617 million that had been in the prior strategy, as reported.

Investors certainly will be evaluating distressed team experience as well as asking managers about their deal sourcing capabilities and how they will manage downside risk in this uncertain market, Angelico says.

“Are there structural protections in place?” he asks. “Is it cheap enough? How will you control the outcomes of difficult situations?”

Investors will want to see managers with specific skillsets, Pardee says.

“Who has the stressed, distressed, transitional skillsets?” he says. “Those are the ones that limited partners will spend more time with now. We expect limited partners to still do their homework.”

Wilshire sees one set of near-term “clear and present” opportunities, such as better pricing on leveraged loans and
corporate debt because of market dislocations, Angelico says. There is also a still-forming set of future investments in the structured credit markets in areas related to collateralized loan obligations (CLOs) and asset-backed or specialty finance lending, he says.

It’s also likely that consultants and investors scouting this new distressed debt and special situations market will tilt more toward existing managers rather than new relationships, and to experienced firms rather than outfits pivoting to add new strategies, Angelico says.

“The groups that we have had contact with on a more regular frequency are where more of our conversations are right now, given how fast it opened up,” he says. “The markets became dislocated so quickly that we have to have that capital in their control sooner rather than later.”

The coronavirus chaos is taking its toll on fund managers’ capital campaigns.

Operators across the country are postponing initial and final closes, or discuss­ing doing so, as investors focus on the dire outlook for their own investment port­folios. Among the shops pushing off dates are Encore Capital of Boca Raton, Fla., Newport Capital of Chicago, and TerraCap Management of Estero, Fla.

In addition, market pros say they expect few managers to roll out new offerings right now — with the exception of opportunistic vehicles looking to capitalize on the market dislocation.

One fund executive said investors are “in triage mode. They don’t want to know about the next fund someone’s going to launch. They want to hear about their exist­ing portfolios.”

To be sure, some managers haven’t delayed or canceled capital raises. But closings have slowed noticeably, placement agents said.

“We have seen closings in the back part of March,” said Alan Pardee, co-founder of Mercury Capital, a New York advisory firm. “Few and far between, but they have occurred.”

Doug Weill, co-founder of New York-based Hodes Weill & Associates, said managers and institutional investors are in fre­quent conversations about market conditions, asset valuations and potential future fund-raising opportunities.

“We are counseling clients to limit marketing in the near term,” Weill said. “It’s not productive to be pitching an offer­ing to a new institutional relationship at this moment in time, when most institutions are prioritizing assessing their current portfolios.”

David Frank, chief executive of New York placement agent Stonehaven, said the situation is worst for an operator that already had an initial close for a fund and began deploying it before the coronavirus crisis. An investor putting in new capital would effec­tively be buying into assets at pre-crisis values, he said.

“It’s like entering the S&P 500 but at January’s level,” Frank said. “Why would anyone do that right now?”

Frank said it could make the most sense for a manager to stop raising money for a such a vehicle, and instead launch a new fund with an opportunistic strategy targeting the current market dislocation. However, that means going back to the original vehicle’s committed investors and letting them know they will be the only ones in that fund — meaning they have larger-than-expected exposure to those assets.

“If you’re caught in that, it’s a wedge,” Frank said. “You bet­ter have very good [limited-partner] relationships.” He added managers may also turn

to offering individual deals to inves­tors to quickly raise capital for specific investments.

Pardee said that investors seem to have fallen into three camps. Many are continuing to schedule meetings, albeit via video-conferencing, and moving toward making commit­ments. Others are sitting out for a few months as they take stock of the initial damage to their portfolios. And a third group is still putting money out — but only to managers they already have longstanding relationships with.

“Some managers that are about to close are seeing inves­tors increase their allocation to a fund, as they want to have capital available for investment, particularly with a manager they know and trust,” said William Thompson, senior managing director in Evercore’s private-capital advisory group.

Managers that have already held an initial equity close also face a timing issue. After that first close, operators usually have a time-stamped deadline of 1-2 years to hold a final close. Given the current market pause, some managers could run out of time to raise more money, or have to ask their initial inves­tors for an extension.

“We’re fortunate in that the clock’s not ticking on us,” said one manager pushing off an initial close. He added investors won’t necessarily be willing to grant more time. “They aren’t always that nice. They think about their returns and what’s best for them. I’ve seen that in the past.”

Investors, meanwhile, are grappling with the “denomina­tor effect.” As the values of their securities portfolios decline, some institutions’ real estate holdings suddenly account for a larger percentage of their total assets. Take Ohio School Employ­ees. The pension system last week reported that due to falling values of other investments, its real-assets portfolio has hit its allocation cap of 17% of total assets, up from 14.7% at yearend.

Market pros say the denominator effect may prove to be tem­porary, however, since property values eventually will have to be written down to reflect the economic effects of the virus.

Another potential fear for managers is that institutions might fail to fund capital calls — although market pros say that’s unlikely to happen soon in more than a handful of cases. More likely, they say, fund shops and their backers would have conversations about waiting to draw down capital, to avoid such defaults.

Looking ahead, the market disruption could prompt limited partners to prioritize funding their biggest managers, partic­ularly ones raising capital for strategies that will look to take advantage of distressed assets.

“There was a haves and have-nots market before,” Mercury’s Pardee said. “Now the haves will have a little more and have-nots will have a little less.”